What’s up with the price of oil?

Question: What about the extraordinary movements in oil prices? Do these refute Peak Oil?

Answer: There is neither anything unusual in these things, nor are these price movements unique to oil. Here are some brief answers, with links to longer discussions.

Oil prices rose along with commodity prices during the boom

The price of commodities varies with global economic activity

In recessions the price of oil drops below the marginal cost of production

Effects of the recession on peak oil

1. Oil prices rose along with commodity prices during the boom

The prices of most industrial commodities have increased since 2003. When a wide range of industrial commodities rise in price (especially vs. gold) we can examine each individual commodity to determine specific reasons for the rise. That is probably pointless, as there is likely a common cause. In this case, all have strong price elasticity to rising global GDP. This is easily understandable, as demand increases far faster than existing mines can be expanded or new mines (or oil fields) developed.

In the most recent cycle (roughly since 2003) copper increased slightly more than Brent oil. (The sensitivity of copper prices to economic growth has earned it the nickname of Dr. Copper.) Small changes in demand for commodities produce large swings in price because their production can quickly be changed only by small amounts. When production from existing sources is at its maximum, as happened during this long boom, the only responses to increased demand are …

a price increase that “destroys” the excess demand, or

price increases sufficient to justify opening new mines.

During the past few years of record global growth we saw both happen to a wide range of industrial commodities. Now we see that this process works equally well in reverse. Small declines in demand produce large changes in price. So it has ever been with commodities, and will be so for the foreseeable future.

My guess is that the global downturn will be long and deep. Perhaps a drop in world GDP of 1% or even 2% sometime during 2009 or 2010. Much depends on the economies of the emerging nations, esp China. If China’s GDP crashes from the low-teens to zero (or negative!), then the global recession probably will be long and hard. Nobody — probably not even China’s government — knows what will happen. We are “off the map” of the post-WWII era, with few precedents to help forecast events — and no clear precedents.

Global GDP has not gone negative since 1970 (there is not good global data before that). During the major slowdowns – 1975, 1982, 1991, and 2001 — it never dropped below 1%. Growth was unusually rapid during the recent expansion (an extraordinary rate of almost 5%/year for 4 years; see the IMF data mapper for details), and the downturn might be equally large.

That is what the crash in commodity prices suggests. Oil from almost $150 to the $50’s. The crash in scrap steel prices (roughly from $600 lbt to $200). Likewise copper and the other industrial minerals, most of which now trade at prices below their marginal cost of production. Miners that had great profits are now have low profits. High cost producers are losing money.

3. In recessions the price of oil drops below the marginal cost of production

Almost every industrial commodity is now trading like at or below marginal cost of production. Mines are closing, expansion plans cancelled. For oil:

This is typical during recessions, and is one reason inflation declines during recession. General price levels can go negative (deflation) during deep recessions (and depressions).

From another perspective, this is why mines have high cost of capital. They must make really good money during booms, because they lose money (or even go bust) during downturns.

Unique to this cycle is the combination of pressure from both low oil prices AND greens. I suspect the resulting crash of investments will surprise both sides, and the finger-pointing after oil prices skyrocket will be deserve both laughter and tears (yes, the world will eventually recover, and with it oil demand).

It pushes the date of peaking back. Consumption falls, so supplies last longer.

It makes a supply shortage (not the same thing as peak oil) more likely during the recovery. Energy and capital investments will crash during the recession (this process has already started).

It means that our preparation for peak oil (aka as “Mitigation”) might stagnate or even reverse, if investment in research and development of alternative energy sources crashes along with oil prices.

Result: If peaking occurs during the next 10 years we will be far less ready, and the consequences worse, than if oil prices has remained above $100.

For example, plans to expand bitumen mining (aka “oil sands”) production in Alberta are being canceled.

It need not be like this. The recession gives us more time to prepare for peak oil. If we use this time to force energy investments — using government funding and regulation to over-ride the price signal — than we might be well-prepared for peak oil (whenever it hits).

Afterword

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10 thoughts on “What’s up with the price of oil?”

Here’s hoping we see the timeline for cresting the Peak pushed back, but I am not sure. Yes, we will see significant demand destruction/reduction as the recession decays into a serious credit deflation (again, my opinion) and depression, but, as you point out – it will also result in a reduction in funding directed towards building out infrastructure in the tar sands, in deepwater and in throwing money at tertiary recovery efforts. With depletion running a potentially devastating clip (from 4.6% up to 9% per the recent IEA World Energy Review 2008 survey, and as bad as 15% at Cantarell, a major source of supply for the U.S.) this combination of low prices, shrinking demand and depletion could mean we have already seen Peak Oil. When recovery comes and demand increases again – will there be enough infrastructure to pump 85 mbd ever again? Will there be enough alt fuel available to make up the difference? We shall see.

Yes, I believe you to be correct when you state “…The recession gives us more time to prepare for peak oil. If we use this time to force energy investments — using government funding and regulation to over-ride the price signal — than we might be well-prepared for peak oil (whenever it hits)…”

The big “if” revolves around using this time to force energy investments. These investments are all massively capital intensive. If the U.S. can keep its AAA rating on its bonds in the face of all these bailouts, then we have a chance to use serious government cash to force a buildout. If not, then the funding could dry up very quickly as the banks suck it all up in a desparate attempt to retain the illusion of solvency.

Excellent presentation. This is indeed the time that we should be making preparations for future petroleum scarcity. Alternatives such as clean coal (including BTL) and modular nuclear reactors for powering an electrical vehicular fleet are both needed.

Research into oil discovery and recovery is apt to continue even during a recession, so that when the prices rise and the investment capital becomes available once again, reserves will be higher than at present.
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.Fabius Maximus replies: The point of the articles I cited is that research and development by the energy sector — almost all forms — is already being slashed, and we’re only at the start of the downturn.

I believe you posted a link to a good paper on how futures trading contributed to the run up in prices and presumably, now contribute to the fall. The point made there was that hedge funds and the like noticed oil futures were counter cyclical to certain other investment classes. These funds waded into the futures markets exploiting this effect with huge futures purchases without ever intending to take delivery. They hoped to piggyback on the decision making of the “real” players, but unavoidably affected prices through their activities. Their sudden withdrawal from the futures market caused at least some of the vertical “gapping down” in oil prices we have seen.
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.Fabius Maximus replies: My posts mention several studies saying the opposite. It is an absurd theory, with almost no supporting data.

This theory is another manifestation of the ever-popular meme “blame speculators.” This surfaces in some form in almost every crisis, to the delight of the ruling elites who have a simple target to blame.

Determining the net effect of the price of oil on the UK and US is complicated by the fact that they are producers of high cost of extraction oil (eg UK’s North Sea oil). Higher prices matheir own oil more profitable.
I heard some thing about massive amounts of scrap accumulating in overflowing depots the other day

There is another, partial and short term, factor as well, unwinding of hedge fund positions (plus others who should know better). During the collapse in share prices, property, etc, a lot of hedge funds took positions in commodities. As the general financial postion collapses we are seeing unwinding of a lot of ‘long’ postions (bets really). This is having a disproportionate impact, as it is happening at the same time as lowering demand.

*** Now speculation was not a dominant or causative affect, rather a reactive and amplifying affect, to an extent that is frankly unknown. Large swings happen when supply/demand becomes very tight, all by itself. ****

Naturally the oil producers are lowering production in response, just as car manufacturers are doing – so it is nothing sinister (so much for the conspiracy nuts).

The tragedy is that high oil prices are necessary:

(1) To encourage more exploration and development to replace declining oil fields (eg North Sea and Mexico).
(2) To encourage investment in oil replacing alternatives.

Now the drop in demand is quite small (only a few percent or so), but in a tight market (where demand and supply are finely balanced) very small changes can have huge impacts on prices, causing wild swings which are of course amplified by speculation. Eventually speculation washes out of the system (= they run out of money) and the fundamentals dominate again. So my expectation is that oil prices will drop for a while and then begin to rise again, though they might not rise enough for (1) & (2) to happen.

So despite the personal relief (and for me personaly, when you drive 7,000km in a couple of weeks small drops really add up) it is actually a really bad thing, we need high (not rediculous though) oil prices to achieve (1) and (2). A few years of $80-$100 would be almost perfect.

There is a looming danger, low oil prices now could mean collapse in investment in (1) & (2) then in a few years supply contraints mean more price ‘spikes’, even if demand only increases a bit or even stays constant, possibly ‘spiking’ any nascent economic recoveries around the world – a real ‘lose lose situation’.
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.Fabius Maximus replies: I agree on all points!

If Gary is right (on this comment), I speak for the Republican Party. Between you and me we then have agreement of the entire politcal spectrum on this issue!

Hey, I stand for the ‘Ancient Order of Skeptics’ political party. A fine old order, everyone should join it. Vote changing is normal. Personally I’ve voted for just about every party that has ever been around, except the extremest nuts of course, in the vain hope that someone we vote for is actually competent. We are always disappointed of course, but then we expect that.

Skeptics get a bad run in authoritarian socities (hey why do you think I like freedom so much). Mainly because we tend to say “Emperor you have no clothes .. and you are butt ugly as well”. The secret police don’t like that, so we tend to have a short life there. Free societies sort of tolerate us in their good times .. and then, in the bad times they run to us like fish who have been taken out of the water for 10 mins, desperately seeking some water. ‘Cause we are more prepared emotionally and intellectually to deal with extreme issues (been round my emergency situations a lot of times … there was the time underwater at 33m when an unscheduled ship came through and I was looking after 10 divers ….).

In extreme times we are worth our weight in platinum. Because we see things as they really are and usually have realistic ideas (radical thought I know) about how to fix things. Think of us as the backup systems of the human race.

Plus we tend to be extremely honest, extremely good looking, hugely honourable people and incredibly intellegent as well (possibly one of those is correct, then again possibly not, except for the ‘honest’ part).

Smile FM (and embrace the ‘dark side of skepticism .. trust me you will enjoy it).

The commments by Memmel are particularly interesting, in that he argues that the financial crisis has dislocated the commodity markets, due to credit failure. This means that the standard supply/demand curves are not working. The implication is that it could take quite a while for markets to start functioning ‘normally’ again, and that price mismatches relative to the real supply/demand could persist for some time. Anyway please read the article and associated comments, I found them enlightening and quite worrying.

Plus there is an excellent table and chart regarding US GDP. The GDP is adjusted for debt growth, showing that there has been no real increase (non debt related) since 2000. This makes sense (a similar pricture exists for Australia and I wouldn’t be surprised for many other countries). Despite all the rah-rah over economies ‘booming’ over the last few years, the picture for the majority of people has not been so good. In fact, if it wasn’t for the press going on about it, many people would probably have thought that recent times were actually pretty tough, with just about everything getting more expensive and wages pretty static.

Only the ‘perception’ of a wealth increase, the ‘feeling’ that you were getting richer through (mostly) your house price increasing disguised the reality that, on a real money in/out basis, most people were only trading water, or even going backwards. Personally I saw rapidly rising house prices as a sign that the majority (and especially younger people) were actually going backwards, requiring more and more disposable income just to have an essential roof over your head. For the young it has been disasterous, a reversal of the usual ‘older generation handing over wealth to the younger one’, more a ‘the older generation mining the younger one of money’.

More proof that assumptions about ‘rational economic man’ only exist in Star Trek books … on planet Vulcan.
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.Fabius Maximus replies: As is so often the case at “The Oil Drum”, the data is excellent but the analysis is bizarre. A mish-mash of things, poorly fitted together.

Gail the actuary makes no attempt to consider the simplest explanation: oil consumption is dropping because global activity is dropping. It’s called a recession, an inevitable part of the business cycle. Only after accounting for the effect of this normal cyclical event — which she does not even consider — should extraordinary factors be evaluated.

To take the analysis one step futher, global economic activity (the biz cycle), typically if imperfectly measured by GDP, is dropping for complex reasons — including the excessive build-up of debt in many (not all) developed nations (but not emerging nations). Plus structural factors (collapse of the “Bretton Woods II”). And probably other reasons, which will become clear long afterwards.

IMO memmel’s comments are almost gibberish, but that discussion would take more space than available here — and more time that I believe they deserve. Only one comment:

“Only the ‘perception’ of a wealth increase”

Most forms of wealth are to a large degree perceptual. Social constructs, given value only by common agreement. Like the little green papers we call dollars (technically perpetual zero-coupon unsecured notes). Or far more complex, the fractional ownership certificates called stocks.

FM: Memmel is an aquired taste. It took me a while to translate what he was on about, but once I did I began to appreciate his often off-centre comments and ideas, doesn’t mean I agree with them but I have found them quite interesting and thought provoking nonetheless.

His key point, about (hopefully) temporary commodity market dislocation is an interesting one.

For others reading this post: he argues that the credit crunch, particularly the collapse in the ‘letter of credit’ market has disrupted world trade. For commodities in particular this means that the normal supply/demand relationships has changed from a “a supplier gets the price that someone is willing to pay” to a “a supplier gets the price that those who have any ready cash “can” pay (a much smaller group of course)”.

This can cause a short term dislocation, where normal buyers cannot get into the market at all as even solvent buyers may not have the resources to fund upfront (say) a full tanker of oil, from loading and shipping to docking. Normally this process is lubricated by credit (one of the oldest forms of credit at that). Take the ‘oil’ (sorry) out of the engine and it seizes up, which is what things like the Baltic Dry Index are showing.

In technical terms the supply/demand relationship is changed as the pool of sellers/buyers and their financial resources have changed dramatically. Basically he argues that the current prices are being dominated by a secondary effect, rather than the usual primary ‘willing bures/willing sellers’ one. Eventually it sorts itself out, credit will begin to flow again, etc, etc.

My gut feel is that like the hedge funds unravelling, it is quite possibly another factor causing ‘overshoot’ in price changes (and not just for oil of course).

FM: I agree a lot of ‘wealth’ is purely psychological but .. there are some types that are real and measurable. Example: if, due to a good health system and better treatments, I am much healthier and live a lot longer than previous generations then I am much wealthier in real terms. If this is because previous generations paid for research, training and put their taxes into a general health system that benefited them to an extent, but more their children, then their investment has paid a measurable return. Ditto many other areas.

I think we need an audit to seperate out real and ‘psychological’ wealth increases, if for no other reasons to guide future investment decisions. Another example (not for you FM you know this, for others who may be reading this): If we pour money into existing houses, thus creating a speculative ‘bubble’ that raises their prices, is this an efficient use of resources vs (say) a new national smart electricity grid?

At the extreme end, if even a fraction of all that money, apparently wasted, had been put into (say) 3-4 more fusion energy projects, over and above ITER, what would have been the probability that one or more would be commercially workable within (say) the next 10 years?

If we don’t start to get rational real soon, dare I say it ‘skeptical’ (in the truest sense), then we risk repeating the same old rubbish again and again .. will it take Depression #86 before we start to get wise?
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.Fabius Maximus replies: Your point about health as wealth is great and perfectly illustrates my point (I wish I’d thought of it). Many “tangible” forms of wealth have value only in our minds — from a social consensus. Native Americans use of sea shells as trading currency; our use of gold.

Physical health — as an individual and in aggregate for a society — is not considered “wealth” by economists, as it has no clear monetary measure. But it is wealth in the purest form.